In many electronic exchange systems today it is possible to trade so called combination orders. A combination order is an order implying the simultaneous trade of two or more contracts. The combination contract for which the orders are given can be set up as a separate instrument and be traded as such or the order is entered as a combination order into two or more instruments without a specific name for the combination order.
In derivative exchanges combination orders are usually called things as straddle, strangle, bull or bear spread etc. However, in a system trading cash instruments, e.g. bonds, stocks etc, combination orders usually do not have any special names as in the derivative exchanges.
The reason why combination orders exist is that a strategy can be entered via the combination order and the electronic exchange guarantees that all parts of a complex transaction is executed if a deal is closed. The different parts (sub-contracts) of a combination are sometime termed legs and this term will be used hereinafter.
As an example, assume that a combination order is entered in two instruments where as a first part of the order, contract A, is to be sold and as a second part of the order, contract B, is to be bought. The system will then guarantee that the legs A and B, i.e. the selling of contract A and buying of contract B, will be executed at the same time.
Combination contracts are today set up with natural numbers as ratios. Thus if size one of A is sold then one, two, three, . . . is to be bought of B. The most common ratio between legs in a combination contract is one to one ratios. Meaning that if one contract of A is sold one contract of B is bought.
If the ratio is one to one, the price of the combination order is the price of contract A minus price of contract B. Thus, if the contract B costs more than the contract A the price of the combination will be positive since the order in the combination will result in a cash outflow.
Furthermore, the input of a combination order in an automated exchange system usually generates so called baits or derived orders. Baits are orders in the outright market of the legs comprised in the standard combination set at prices such that the combination order as a whole will match the prices of the legs in the outright market. This bait generation is made in order to increase the liquidity in the outright instruments as well as for the combination contract.
The derived orders are in a conventional automated system generated by the matching process as a result from a combination order. As simple example, assume that the combination order is to buy one contract A and sell one contract B. Assume further that there is an existing order in the outright market to sell one contract A at a particular price. However, there is no order to buy one contract B at a price that would match the price of the combination order. In this case an order to sell one contract B could be generated in the outright market. Thus, to continue the example, assume a trader who wants to buy the combination Buy_A_Sell_B for a price of 2 at volume 50. The combination order implies that the trader is willing to pay 2 more for each contract bought of A than sold of B. Assume further that there exists a sell order in the market for A at price 100 and volume 25. In this case the submission of the combination order can result in the generation of a bait (derived order) to sell 25 B at the price of 98. If someone enters into the trade against the bait, a simulations trade will occur in A at the price 100 for the volume up to 25. The reason why the bait is generated at the volume of 25 is that this is the only volume that can be guaranteed to be executed. Thus, no additional volume should be generated as a bait even though the order in the combination has a volume of 50.
The ratios between the buy and sell orders in a combination contract are in a conventional exchange always natural numbers and that is a big limitation. The reason for this is described below. A natural number limitation is usually not a major problem when strategies of options or equities are to be traded. However, if trades are to be done in bonds or similar financial contracts, between different products, hedge options with futures or the underling stock, index and similar types of contracts, the ratios are to be calculated by some formula in order to provide maximum benefit.
For example, if an option is to be hedged with its underlying financial instrument. Then the volume of the underlying instrument should be hedged by the delta value of the option in order to minimize the risk involved, or worded differently optimize the effect of hedging operation. In the case when a bond is traded against another bond the hedge ratio may be calculated to be duration neutral. The duration of the bond is often considered to be the risk of the bond. In these cases the ratio between the legs in the combination contact traded will not be a natural number.
As a further example, assume a switch of bond C to bond D by selling bond C and buying bond D. The volume of bond C is given by the sell order to be 10. The volume of bond D is then calculated to be (volume order)*(duration of bond C)/(duration of bond D). This volume is almost by certainty a non-natural number. At first glance this transaction can seem to be straight forward, but since the price of the bond is determined by the duration of the bond, the duration has to be calculated dynamically depending on the price in the outright market of the bond. To calculate the duration of both bonds in the combination the price of one of the bonds has to be known and also the price of the combination before the volume of both bonds can be calculated. The price of the combination may be set in a price difference, the price of the combination is fixed even though the price of the legs change, as in the normal standard combination explained above. It may also be priced as a yield difference between the two or by some other standard.
Regardless of the pricing mechanism used, the ratio of the volumes cannot be set as natural numbers. The same holds for the trading of covered options as described above where the delta value is dependent on the price of the option as well as the price of the underlying instrument.
Thus, there are many combination orders where the ratios between the legs in the combination are not natural numbers. These include covered options, future basis trades, switches of bonds etc., where the weight and/or the price is derived by some formula.
In an automated exchange system a major bottleneck is the matching unit, where all matching takes place. The calculations of any ratios different from natural numbers result in a very high load on the computer processor used. Therefore, no existing system makes such calculations.
A conventional way of increasing the processing power in a matching unit is to partition the execution into two or several partitions each operating on a different set of data. For example one partition may operate on data for a first type of financial instruments whereas another partition operates on data for a second type of financial instruments.
However, such a solution will not work if the matching unit is to match combination orders and generate derived orders because different legs of the order may be processed in different partitions. This is because the matching process calculates the prices as well as the volumes of the derived orders. Hence, it is not possible to have combinations of instruments belonging to two different partitions, because a simultaneous execution of all legs cannot be guarantied. It is therefore not possible in existing automated exchanges to add any advanced calculations for bait generation, since that will make the matching process very slow.